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Analysis
Blockchain beyond the hype

Blockchain beyond the hype

Technology reduces counterparty risk and aids regulation

by Bhavin Patel in London

Thu 1 Mar 2018

If you believe the hype, blockchain is a revolutionary technology that will transform the way financial services operate. However, the 'year of the blockchain' is yet to materialise.

In the context of finance, blockchain can be defined as a digital platform that uses cryptography and a distributed messaging protocol to create a link between two or more parties to transfer asset ownership. The transaction is registered across a network of computers, in a distributed ledger.

The promise of blockchain cannot be ignored. In capital markets, the technology has the potential to settle currency, equity and fixed income trades almost instantaneously, creating an opportunity for banks to eliminate intermediaries.

Institutions are not switching their business models immediately, as interoperability is a problem. Blockchain attempts to transfer value from one party to another and reconcile the changes to their respective accounts quickly and securely. This requires all parties to be on the same blockchain system and access the same data. Given the number of competing systems, this is impractical. Additionally, as a system grows, the speed of transactions suffers.

Blockchain payments are not fast enough to support large-scale operations. For instance, the bitcoin blockchain is unable to process transactions at the speed required by banks. At most it can handle seven transactions per second. In comparison, Visa averages 2,000 and can scale up to 56,000 transactions per second if required.

As chains grow they become unwieldy. Private ledgers tailored to overcome this lag are in development, but these ledgers will not interact with each other. Groups such as R3, which has 41 banks as members, are seeking to overcome this issue by developing a standardised, interoperable platform.
A blockchain is needed in a multiparty agreement where no one trusts each other and there is an opportunity for deception.

The decentralised nature of blockchain means there is one time record of a transaction and the data are replicated through nodes. Nodes are important members of the network that validate transactions. Participants in the system cannot lose or destroy transactional data without incurring high costs.

The adoption of blockchain has been transformational for certain industries, especially for companies in parts of the world that lack the infrastructure to transfer large-value contracts, or where centralised solutions are unreliable and open to corruption.

In the diamond industry for instance, a distributed ledger can be used to track the history of ownership back to the mine. The blockchain generates a tracking key, which is etched into the diamond.

Blockchain technology can drive solutions even without implementation. The first step towards implementation involves a company agreeing on data and processing models. Human factors are usually responsible for causing problematic noise in data, which is one of the problems the distributed ledger aims to solve. Harmonising data standards can solve most problems, without the need for the company to implement a blockchain.

Blockchain operates continuously, while traditional transaction processing has a two-day settlement period. Legislators and regulators have not caught up with the need for real-time regulation.

If a regulatory body adopted a node in the blockchain system, it could see all the information in a market, making regulation more effective. There is no backdoor in the market.

Monitoring the stability of the banking sector could be easier if the Financial Stability Board used blockchain. If a blockchain recorded every instance of a bank failing to make a payment or transfer assets, the regulator would have the power to act quickly to stop the bank from trading, or inject emergency liquidity if required.

Blockchain could become the backbone of capital markets infrastructure, reducing counterparty risk and settlement times, and increasing regulatory transparency. The system will only ever be as good as the information built into it which is why much more work lies ahead.

Bhavin Patel is Economist at OMFIF. This article first appeared in the February edition of The Bulletin.

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